/ 13 June 2011

The mortgage vs retirement fund debate

It is not often that you attend a retirement conference and a speaker encourages young people not to save for their pension but to rather pay off their house.

Addressing a group of trustees at an Alexander Forbes summit on The future of benefit design, Anthony Asher, an employee benefits expert from Australia argued that forcing young people to save into a pension fund and the introduction of compulsory preservation is “an assault on the young, it is a decision made by older people telling them to save”.

He argues that young people are faced with enormous liquidity constraints. The financial pressure on young couples trying to buy a home and educating children is causing marital issues. He advocates focusing on settling your home loan and then boosting savings once your house is paid off and the kids are financially independent.

He concluded by saying that forcing young people to save in a pension fund just benefits the industry.

The room broke into applause, and it made for a refreshing change from the standard “save for your retirement from your first pay cheque or you will be doomed to cat food in retirement” mantra.

So I decided to run the numbers. The results are surprising:

I have assumed a 25-year-old starting work at a total salary of R20 000 and after tax pay of R16 000. For simplicity I have ignored salary increases, which at this age should be substantial as your career progresses so one needs to adjust savings each year by the salary increase.

Pay off your bond first, save later
At age 25 you start saving 20% (R3 200) of your after-tax salary for a deposit on your first home.

By the time you are 30 you have saved R278 000, assuming a 10% per annum return and no salary increase.

The averaged priced home is around R770 000 so you would need to take out a home loan of R500 000.

Your monthly repayments are R4 500. You continue to put your 20% savings into your mortgage over and above your normal bond repayments and your total monthly payments would be R7 700 leaving you with R8 300 for living expenses.

At this rate you will have paid off your house just over seven years by the age of 37.

Now you start saving that 20% (R3 200) into your retirement fund and you extend your retirement age to 65-years-old, giving yourself 28 years of saving.

Assuming a return 5% above inflation, by the time you retire you have saved R2.3-million in real terms (in today’s value).

That would buy you an income of around R150 000 a year, or R12 500 a month. That is 75% of your take home pay.

You would also have R4 500 of additional income once your house is paid off to enjoy your lifestyle. You could add that to boost your retirement savings; however you would not receive a tax benefit as the pre-tax retirement funding is limited to 22.5% of your salary.

Based on Asher’s proposal you could be debt free by the age of 37 and have enough retirement savings plus an increase in your cash flow.

Split your savings between retirement and home
In this scenario you split your savings: 10% retirement provision and 10% paying off your home.

Retirement funding is before tax so your 10% saving is on your full take home salary (R2000 a month).

At the age of 65 your retirement fund will be worth R3-million, assuming a real return of 5%, this would give you an annual income of R195 000, equal to your current after-tax salary and R45 000 more a year than the previous example.

If you retired earlier at age 60, you would have the same lump sum as the previous example.

 If you save 10% for a deposit on your home, you will have a R124 000 deposit at age 30. To buy the same property you will have to take out a mortgage of R654 000.

To be in the same cash flow position as the previous example, in other words to have R8 300 for living expenses, you would only be able to pay an additional R200 a month into your mortgage.

More of your savings is going to interest than capital in this example so it would take 18 years to pay off your bond. You would be bond free at the age of 48.

You wouldn’t actually have to add any further savings to your retirement fund as you are already well provided for and you would have R6 100 of “spare cash” which means you could plan to retire earlier or cut back on your working hours.

Based on these examples, you are better off using some of your savings for retirement provision. This is because:

  • That R400 extra that you can save due to the tax benefit boosts your retirement fund by R600 000 in retirement.
  • The power of compounding means that your pension savings double every 13 years in real terms, so the sooner you start building a lump sum the more returns it will generate over time.

However, Asher’s point really was that few young people can afford to buy a home and save 20% of their salary. Coming from Australia the cost of housing makes it almost prohibitive for young people to become home owners. The situation in South Africa is not quite as dire and the reality is that car repayments are usually the real reason people do not have enough to save for retirement.

So what if you can only buy a home by forfeiting savings? In this case you could buy a home at age 30 and pay it off over 15 years by increasing your payments with your salary increases.

If you then start saving for retirement at age 45, you could theoretically save 30% of your salary which was going to home repayments and increase this to 40% of your salary from age 55 to 65 once the kids have left home.

You would probably just scrap enough together for retirement but where is the fun you were supposed to have when the kids left home? Where are the overseas trips and the shorter hours or that business you always planned on starting? It is doable but at quite a sacrifice.

This is an important consideration when deciding how much to spend when buying your home. What are you sacrificing in the future by stretching yourself today?

What it also does not take into account is that few people retire in the house they bought at age 30.

They have usually up-scaled and taken on a new bond and new financial commitments pushing that debt free age from 45 to 55. Then it really is too late to fund a decent retirement.

The good news, for a young person, is that the example shows even if you only save 10% of your salary from age 25, you will have sufficient funds for retirement. You don’t need to save nearly as much, if you start saving from day one.

A smart strategy is to maximize your savings from the age of 25 to 30, then cut back (not cut out) whilst you juggle the house and kids for 20 years and then increase your savings again from age 50 whilst keeping some aside to have some fun.

Next week we will look at whether it pays to cash in your pension and pay off your mortgage

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